Rate cut will help block Europe shock

With the European financial crisis dragging on and divisions between the mining and non-mining sectors of the economy getting wider, the Reserve Bank of Australia faces an increasingly tough decision at its policy meeting next week.

That said, I’m warming to the view the RBA should provide a further timely cut in rates next week due to accumulating evidence of a significant loss of momentum in the non-mining parts of the economy.

To my mind, slowing economic momentum leaves us at risk of toppling over should a sudden shock from Europe come our way.

Of course, the unemployment rate is only 4.9 per cent, and retail spending spiked higher in March. Employment growth has also picked up and the mining investment juggernaut is steaming ahead.

Yet the housing sector is contracting, consumers are worried about their financial position, and reports of job losses are mounting.

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Financial markets appear in little doubt rates will be lower next week. Not only is a 25 basis point cut in the official cash rate already priced in, traders also see a modest chance of yet another 50 basis point cut.

But such aggressive market pricing also reflects a small chance of a very large cut in rates (by, say, a full percentage point) should Europe implode in the next few weeks – rather than just a certain view rates will be lowered by 25 basis points next week.

Europe aside, the main focus is the domestic economy. Outside of mining, conditions appear so weak that the overall economy seems destined to keep growing at below-trend pace without the aid of lower interest rates.

The overall business conditions index in the National Australia Bank business survey, for example, tipped into negative territory last month, and the ANZ measure of job advertisements slumped by 3 per cent. Home building approvals and demand for home loans also continue to trend lower, while the Westpac/Melbourne Institute consumer confidence survey shows household perceptions of their financial outlook remain unusually low.

Only this week we also learnt that business investment intentions outside of the mining sector continue to be wound back. According to the Australian Bureau of Statistics, business investment (in nominal terms) is expected to grow by around 34 per cent next financial year, but investment in “other selected industries" will be flat, while it will fall by a sizeable 12 per cent in manufacturing.

And even in the mining sector it’s not all wine and roses..

While investment in new capacity is coming on strong, this is actually a cost factor to the mining sector – and an element of their recent upgrade to planned investment spending reflects cost overruns.

Meanwhile, commodity prices and mining stock values are falling while costs are increasing.

Against this background, and with underlying inflation low, the current setting of interest rates increasingly appears insufficient to support the economy.

Indeed, due to higher bank funding cots, it’s worth recalling that last month’s larger than usual 50 basis point official rate cut only produced a quarter of a percentage point cut in key business and home loan lending rates relative to the levels at the start of the year.

This month’s cut in variable mortgage rates leaves them just over one quarter of a percentage point below their average since 1996, which should be considered only mildly expansionary.

What’s more, European tensions suggest the pressure on global wholesale bank funding costs remains, meaning the RBA may well need to cut rates just to forestall any further unilateral lift in lending rates by the private banking sector – or a crunch in lending conditions due to a cut in profit margins should banks refrain from raising their lending rates.

Of course, the RBA could always hold its fire and wait to see the impact of its latest rate rise. But the evidence to date already suggests that the rate cuts of last year had little impact on reviving local demand.

To my mind, given today’s more leveraged household balance sheets, the weakening in housing and sharemarket wealth over the past year is offsetting the stimulus provided by lower interest rates.

Undue fear over the carbon and mining taxes is also taking a toll, while the government’s large fiscal drag is not helping.

A cut in interest rates next week can be justified to bolster flagging momentum in the non-mining sectors as insurance against a sudden European-inspired collapse in global equity markets and business confidence.